Yesterday, we had our Week 3 session at the Colloquium, featuring Kim Blanchard's 's The Tax Significance of Legal Personality. This came after we were forced to cancel our Week 2 session, concerning David Kamin's In Good Times and Bad: Designing Legislation That Responds to FiscalUncertainty. The Kamin session was a casualty of last week's NYC Blizzard That Wasn't, which led to NYU's being closed for the day. I will blog here about that paper shortly.
Blanchard is at Weil Gotshal, and is a prominent leader in the NYC tax bar. We frequently have had practitioner papers at the colloquium, although not for the last couple of years, and it was good to get back to this practice.
I see the paper as making both a narrow argument and a broad argument.
The narrow argument is that the question of whether a legal entity, such as a corporation or partnership, is treated by a given country as having “legal personality” should not affect its tax treatment. (While the U.S. doesn’t even have a “legal personality” concept to speak of, in many countries this concept not only plays a general doctrinal role, but may influence the resolution of various tax issues – e.g., whether the entity is “opaque” and taxed at the entity level, or “transparent” with income tax being imposed directly on its owners.)
The paper argues that legal personality, as used in other countries, tends either to be meaningless and circular, or to focus on formal legal attributes, such as the entity’s capacity to sue or be sued, that should not affect the tax analysis. This struck me as a highly persuasive argument, subject only to the question of what people who are more familiar than I am with non-U.S. legal and tax systems would say in response.
The broad argument involves what one might call the ‘enry ‘iggins issue.
In My Fair Lady, Henry Higgins (known to posterity as ‘enry ‘iggins) has a show-stopping song in which he asks: “Why can’t a woman be more like a man?” Whereas the paper asks: “Why can’t a European, Canadian, etc. be more like an American?”
In My Fair Lady, of course, the joke is that the woman (Eliza Doolittle) whom he is castigating as crazy, irrational, upsetting, etc., is in fact much saner, wiser, kinder, more mature, more considerate, more tolerant, and more generous than he is.
The paper argues that U.S. tax law is generally better than that of the other countries surveyed. Better, in that it focuses more on economic substance and less on formalistic legal details. This, the paper argues, makes U.S. tax law not just less manipulable by sophisticated taxpayers, but also more predictable. For example, if a foreign court is basing the availability of treaty benefits on an empty formal concept, who knows how they will come out. Whereas, in the U.S. setting, even if line-drawing issues create uncertainty, at least we know what the issues are.
As a fellow American, who am I to judge whether the critique is fairer of foreign tax systems than ‘enry’s would-be critique of Eliza. But a number of U.S. tax practitioners do indeed report that, when discussing foreign tax law in transactional settings, they frequently are told that one can easily get away things that, in the U.S., would be far more dubious because our rules make some effort to look at underlying economic substance.
The paper also argues that the U.S. check-the-box rules have been over-blamed for “hybridity” in U.S. vs. foreign entity classification. (Hybridity permits, for example, a U.S. company to strip income out of a French or German affiliate into a tax haven without encountering U.S. tax liability under subpart F.) I agree with it that the conceptual causes of hybridity lie deeper than just our adopting check-the-box, but its adoption – with transparent single-owner entities being wholly disregarded (to non-international tax experts: sorry for the jargon here) – was indeed empirically a key trigger for the explosion of post-1997 foreign tax planning by U.S. companies. Whether this mainly hurt countries such as France or Germany that were having their income stripped out, or the U.S. itself, if more taxable income first traveled from here to those countries now that it could be trans-shipped yet further, remains an open empirical question.
In addition, the paper argues that a key reason why the U.S., in deciding which entities should be treated as tax-opaque, pays less heed than most peer countries to commercial law factors, is that we have federal income tax law and state-level commercial law. (For example, one incorporates under the law of a state, not any sort of federal incorporation statute.) While this is plausible, my own explanatory account would focus more on the particular history of Treasury and IRS efforts to curb effective electivity with respect to entity classification, which collapsed under its own weight due to some early mistakes (leading ultimately to check-the-box) and which in 1987 led to a brand-new approach, requiring publicly traded partnerships to be treated as corporations.
In response to the paper’s main subject matter of opaque versus transparent, I agree that using formal concepts of “legal personality” to distinguish between entities that should be taxed at the entity level, like U.S. C corporations, or at the owner level, like U.S. partnerships, is likely to be unhelpful. But I’d limit any defense of current U.S. law by making the observation that one could argue we get it close to backwards, in deciding which entities should be taxed each way.
There are several reasons why it matters which way one does things. Often the key point at issue, under current U.S. law, is that corporate income is at least theoretically double-taxed. This makes little direct sense, although one could view it as responding indirectly to the failure of the entity-level tax, or as not worth eliminating in mid-stream given transition and revenue issues.
But leaving aside double taxation (which is not a necessary consequences of imposing an entity-level tax), it’s generally preferable to levy taxes at the owner level, not the entity level, if one can do that well enough. In cases where an owner-level tax is sufficiently feasible, the main thing one achieves by imposing tax at the entity level is (a) applying the wrong marginal tax rates, relative to those of the owners, and (b) making the taxpayer’s residence more tax-elastic. This can reduce both efficiency, by distorting entity choice, and distributional objectives, by creating failures to impose the desired marginal tax rate (or any positive tax rate).
So, the basic way I’d divide up the baby is by using entity-level taxation only in circumstances where it is too hard to make owner-level taxation work properly.
When is it relatively easy to make owner-level taxation work properly? I would say, (a) when ownership interests in entities are publicly traded, causing them to have observable market prices, and (b) when all of the ownership interests are pro rata, rather than there being a complex deal in which there are multiple classes of equity, or some hold more of an upside or downside for X asset or activity than Y asset or activity, and so forth.
This offers support for applying owner-level taxation to publicly-traded entities – the exact opposite of the U.S. approach, under which public trading means that you are taxed as a C corporation. Obviously, there are other issues here (e.g., Reuven Avi-Yonah argues for taxation at the entity level given managerial / governance issues). But among those who have argued for replacing the entity-level corporate tax with an owner-level mark to market tax are Eric Toder & Alan Viard, Joe Bankman, Joe Dodge, Michael Knoll, and Victor Thuronyi. Plus, David Miller would impose mark-to-market taxation more broadly and use some of the revenues to lower greatly the entity-level corporate rate. (I hope I am not leaving anyone out.) So right or wrong in the end, the view I suggest here is surely not an eccentric one.
Next, pro rata versus non-pro rata deals. Even without public trading, if an entity’s owners have a pro rata deal, it may be pretty simple to do entity-level income computations and then flow everything through. So why bother with the entity-level tax, which may impose the wrong marginal tax rates, unless for some reason it is hard to find and/or tax all of the owners. But as soon as you have a non-pro rata deal, and a gap between taxable income and economic income, you will face a giant mess in trying to get the owner-level allocation right. In such cases, there is no good answer to the question of whom a tax item really pertains to.
U.S. partnership tax law provides for special allocations of items to particular taxpayers. This represents an effort to get the computation logically “right” under crazy, counterfactual assumptions (e.g., that it’s as if the entity was being liquidated today, with taxable income proving to equal economic income, and with eyes closed to, say, the use of nonrecourse financing that may transfer downside risk from owners to lenders). It has led U.S. partnership tax law into a horrendous morass of excess complexity and widespread noncompliance (I am told), the latter from a combination of less sophisticated taxpayers throwing up their hands and more sophisticated ones relying on audacious legal opinions. And its apparent aim of restricting manipulability has certainly not fared well.
Suppose one got rid of special allocations, requiring either pro rata tax allocation (as I gather some countries do) or entity-level imposition of the tax plus an owner-level integration method. Given that there actually are non-pro rata economic deals, this would still get things wrong, and I certainly can’t say with any confidence or personal knowledge that the end result would be less manipulable than U.S. partnership tax law (although the fact that the devil I know is such a mess almost inclines me to believe it might be).
Anyway, put these two together, and you could say that current U.S. tax law gets it close to backwards. Suppose we had owner-level mark-to-market taxation of publicly traded entities, owner-level flow-through taxation of “simple” entities with sufficiently pro rata deals, and integrated entity-level taxation of “complex” entities, such as those with non-pro rata deals. That would be largely the reverse of current U.S. law (although not entirely, since we do apply owner-level flow-through taxation both to simple partnerships, and to electing S corporations, which must have only one class of stock). So, even if we are wise to ignore “legal personality” as a classification factor, it is not clear how much better we are actually doing.